Now, it does seem fair to say that any "SocNet Bubble" will be far less severe that the tech bubble of late last century, and that is largely due to the smaller size of this event. But maybe sharp practice in the drawing up of accounts for some of these entities means this "bubble" is not as small as it ought to be!

NYU Professor of Finance, Aswath Damodaran, probes this matter in his June blog, where he drills hardest into Groupon's deciding to exclude "customer acquisition costs" from its expenses. Bingo, strip that out and you leap to profit much higher and much quicker!

Aswath homes in on accounting first principles (which are often ignored by accounting rule writers, but that is a different story), and emphasizes: Recognize that all of this reclassifying of expenses does not change your cash flow status.

It seems he understands the centrality of cashflow, and may not need to do the Justonelap thing or the Financial Statements Course course. Maybe he even helped draw up the How they link animation in powerpoint which simplifies corporate accounts in a trice.

A few days ago, Groupon filed an S-1 statement with the Securities Exchange Commission, officially signaling its intent to do an initial public offering.http://blogs.wsj.com/deals/2011/06/02/groupon-ipo-its-here/I do know that there are valuation questions that will come up with the IPO but talking about them will lead me to repeat earlier points that I made about the Linkedin and Skype valuations: the value will depend upon revenue growth and potential operating margins. Instead, I want to focus on a claim that Groupon has made, that has opened up the company for some ridicule in the financial press. In 2010, Groupon generated revenues of $713 million and reported an operating loss of $420 million (see the S-1 filing link below):http://www.sec.gov/Archives/edgar/data/1490281/000104746911005613/a2203913zs-1.htmPretty bad, right? But here's where it gets interesting. In the same S-1, Groupon claims that it will make money in 2011 using a different measure of operating income (which is calls Adjusted CSOI: Consolidated Segment Operating Income). I am already suspicious, because the term carries two pieces that make me nervous - the word "adjusted" and a new acronym for earning. But what is Adjusted CSOI? According to Groupon, it is the income before expensing to acquire new subscribers is taken into account and since this expense amounted to about a third of overall operating expenses in 2010, removing it does wonders to profitability. It is this claim that has raised the ire of financial journalists and of some investors and their argument is encapsulated well in this blog post on Forbes:http://blogs.forbes.com/ericsavitz/2011/06/02/deja-vu-groupons-bubble-1-0-approach-to-accountingIs Groupon breaking new ground in measuring profitability or is this playing with the accounting rules?

To answer this question, we need to go back to accounting first principles (which are often ignored by accounting rule writers, but that is a different story). In an ideal accounting world, the expenses incurred by a firm would be broken down into three groups:a. Operating expenses: These are expenses incurred to generate revenues only in the current period; there are no spillover benefits into future periods. Thus, the cost of labor and material incurred in making a widget will be part of operating expenses.b. Financial expenses: These are expenses associated with the use of borrowed money in the business. Thus, interest expenses on bank loans would be included here as should lease expenses.c. Capital expenses: These are expenses that generate benefits over multiple years. Classic examples would be the cost of building a factory or buying long-lived equipment.Assuming that you can classify expenses cleanly into these groups, here is how they play out in the financial statements. Operating expenses get netted out of revenues to get to operating income, financial expenses get netted out of operating income to get to taxable income and taxes get netted out of taxable income to get to net income. Capital expenses do not affect income in the year in which they are made but have two effects: the first is that they show up as assets on the balance sheet at the end of the year that they are incurred and then get amortized or depreciated over their useful life. The amortization or depreciation is also shown as an expense to get to operating income:Revenues- Operating Expenses- Depreciation/Amortization of Capital Expenses= Operating Income- Financial (interest) expenses= Taxable Income- Taxes= Net Income

So, here is the best possible spin on what Groupon is doing. The cost of acquiring new customers presumably creates benefits over many years, since once a customer is acquired, he or she continues to use Groupon for years (I told you that I was taking the best possible spin here). Using this rationale, you could conceivably argue that acquisition costs are capital expenses and should not be netted out to get to the operating income. However, here is why I am skeptical about whether this is being done to get a better measure of income (which would be noble) or for window dressing (which is not):a. Back up the claim that customers, once acquired, stay on for a while: If you are going to capitalize acquisition costs, the onus is on you to show proof that acquired customers stay as customers (and actually buy products for many years). With strong competition from other online coupon based companies (like LivingSocial), it is entirely possible that customers once acquired, are fickle and move on... If that is the case, the acquisition cost has a very short amortizable life and begins to look more like an operating expense.b. If you are capitalizing acquisition costs, carry it through to its logical limit: This would require amortizing previous year's acquisition costs (which would in turn require an answer to (a), since the amortization will be over the customer life with the company). In other words, you cannot just remove acquisition costs (as Groupon has done) from your income statement, but you would have to replace that cost with an amortization cost.c. Recognize that all of this reclassifying of expenses does not change your cash flow status: The bottom line is that Groupon has negative cash flows and those negative cash flows will get more negative over time, since the company will have to keep spending the money to acquire customers (to get the growth rate it would need to justify a $20 billion value...).

Note that none of this is breaking ground. I have been making this point about R&D expenses at technology firms and advertising expenses at brand name companies for years. In fact, I have a paper on how we need to take a fresh look at companies with intangible assets:http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/intangibles.pdfThis is also a chapter in my book, The Dark Side of Valuation (2nd edition, Wiley)If you want to try your hand out at capitalizing acquisition (or brand name advertising or R&D) costs, try this spreadsheet.

The bottom line, though, is that from a valuation perspective, reclassifying acquisition costs is a mixed blessing. For growing companies like Groupon, it can make the earnings look more positive, but it will also increase the capital invested at these companies (because the acquisition costs will be capitalized). It can alter perspectives on whether the company is actually profitable and creating value: the key profitability number in the long term is not the operating margin but the return on invested capital and Groupon has just admitted that it invests a lot more capital than people realize in what it spends to acquire customers.

The other adjustments that Groupon makes to operating income that are more dubious. It is absurd to add back stock-based compensation (it is an operating expense...) and we are taking the company at its word, when it breaks its marketing costs down into acquisition costs and regular marketing costs. What Groupon is doing is also part of a trend that I find disturbing, where analysts adopt half-baked approaches to dealing with costs like R&D and marketing by adding them back to EBITDA, leading to a proliferation of measures like EBITDAR (Earnings before interest, taxes, depreciation and R&D) and EBITDAM (Earnings before interest, taxes, depreciation and marketing). While this approach deals with a serious accounting problem (where capital expenses are being treated as operating expenses in some companies and thus skewing not just earnings but book values), it does so at a surface level. After all, if we are going to treat R&D and customer acquisition costs as capital expenditures, we should follow up by asking the key questions: How effective are they? Are they creating or destroying value?

Postscript: I forgot to mention that I hope that the tax authorities don't buy into Groupon's argument. If they did, acquisition costs would no longer be tax deductible; only the amortization would. As is often said, be careful what you wish for. You may get it.